For private market investors, betting on an early-stage startup can be a high-risk, high-reward proposition. However, the startup landscape can be difficult, making proper due diligence essential to help find opportunities. Conducting rigorous due diligence may allow you to transform initial insights into informed investments.

Looking Beyond the Surface

An entrepreneur’s pitch deck often provides a resource for their vision. But you may want to consider looking past the hockey stick projections and vet the founder’s assumptions. Early-stage ventures can have many proving points—from product-market fit to scaling capabilities. Due diligence aims to stress test the startup’s business model and growth story.

The management team can be a huge factor. Investors may want to scrutinize the founders’ backgrounds and prior ventures. Do they have relevant experience to execute on this idea? Deep domain expertise? What’s their risk tolerance and ability to adapt? Fledgling startups need resilient leaders who can navigate ambiguity.

Evaluate the market opportunity with a critical eye. Is the startup operating in a stagnant industry or targeting a saturated segment? Be wary of founders touting multi-billion dollar addressable markets without a credible plan to capture share. Early-stage investing is inherently risky, but due diligence can help gauge true potential.

Examining the Financials

For pre-revenue startups, the financials may be limited. Still, assess historical performance to the extent possible. Analyze cash burn rates, operating expenses, debts and fundraising. This may show how efficiently the startup uses capital and progress made.

Also you can evaluate financial planning assumptions. Do revenue growth projections seem reasonable? Pay close attention to unit economic models. Unfavorable unit economics—like high customer acquisition costs—can possibly sink an otherwise promising startup.

Of course, early-stage financials may offer limited visibility. The key could be in understanding how believable the startup’s models are given the opportunity ahead.

Vetting the Product

The product demo can offer invaluable insight. But don’t just take the founder’s word that the product is incredible. Vet both current capabilities and the roadmap strategy.

Evaluate factors like:

• Technical architecture: Is the backend built to scale?
• Core technology: Does the startup leverage proprietary tech or defensible IP?
• Product-market fit: Are initial users truly deriving value from the product?
• Competition: Does the product differentiate enough and address users’ needs better than rivals?

Consider trying the product yourself and consult objective users. You may want to look beyond surface-level polish; you’re assessing the viability of the core technology. It can be important to know the key milestones needed to get the product to the necessary level.

For highly technical products, consider having a domain expert conduct technical diligence. They might be able to better evaluate the solution’s technical merit and feasibility.

Interviewing Third Parties

Startups usually don’t operate in a vacuum. Gathering objective perspectives from third parties can help gauge their standing and reputation.

Ask savvy individuals in the startup’s network for candid thoughts:

• Customers: Are they truly satisfied or seeing promised results?
• Channel partners: How has working with the startup been?
• Former employees: Why did they leave? Any red flags?
• Competitors: What are the startup’s perceived strengths and weaknesses?
• Industry experts: Is the market opportunity legitimate and the solution differentiated?

You can use these conversations to probe the startup’s blind spots. Look for consistency or divergence in feedback. Seek out unbiased sources able to provide nuanced insights.

Evaluating Deal Terms

Early-stage valuations can be based more on future potential than tangible results. Still, consider ensuring deal terms make sense given current traction and projected milestones.

Look at the capitalization table and ownership breakdown. Have previous fundraising rounds included reputable angel and VC investors? Pay attention to pro-rata rights for follow-on investment rounds.

Review proposed investment terms closely. It may be possible to push for provisions that protect against downside risk, like stronger voting rights or liquidation preferences.

Final Thoughts

Ultimately, due diligence isn’t about checking boxes or digging up “gotchas” to avoid investing. It’s about thoroughly understanding a young startup to gauge its viability and support it.

Approach due diligence as building a relationship. Be honest about concerns but also willing to see the founder’s vision. With emerging startups, some risk factors are unavoidable.

Yes, early-stage investing is a high-risk arena. But the downside can be mitigated by educating yourself and researching opportunities. Due diligence can help with investment insight. With a balanced view of the risks and rewards, you can help find opportunities that could meet your goals.

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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.